NOTE: IF YOU WANT THE CRITICAL FACTS ABOUT
INTEREST-ONLY WITHOUT ANY FRILLS, GO TO THE INTEREST-ONLY
TUTORIAL.
April 8, 2003
I
continue to be dumbfounded by the claims about interest-only loans reported to
me by mortgage shoppers. Whether
the claims originate with loan officers or, as one defensive loan officer
suggested to me, they arise in the over-active imagination of shoppers who still
believe in the tooth fairy, I can�t say for sure.
Probably it is some combination of the two. All I know for sure is that misperceptions abound, and I keep
running into more of them.
Misperception
1: Interest-only loans are a type of
mortgage. They are not.
Interest-only is an option that can be attached to any type of
mortgage.
For
example, a 30-year fixed rate mortgage of $100,000 at 6% has a monthly payment
of $599.56. This is the fully
amortizing payment -- the payment which, if maintained over the full term of
the loan, will just pay it off.
In
month 1, that payment divides into $500 of interest and $99.56 of principal.
In month 2, the payment remains at $599.56 but the breakdown is $499.50
and $100.06. Each month, the
interest portion declines and the principal portion rises.
After 5 years the balance is $93,054. That is how mortgages amortize.
Now
lets attach an interest-only option to this mortgage, available, say, for the
first 5 years. That means that the
borrower need pay only $500 a month during the first 5 years.
There is no payment to principal.
If
the borrower exercises the option, therefore, the balance after 5 years is
$100,000. There is no amortization.
Beginning year 6, the borrower must begin paying $644.31.
That is the fully amortizing payment for a 6% loan of $100,000 for 25
years.
Misperception
2: It is less costly to amortize an
interest-only loan. This is
patently ridiculous, but some variant of it keeps popping up in my mail.
Suppose
a borrower takes the mortgage described above with the interest-only option, but
decides to pay $599.56. He
doesn�t exercise the option but makes the fully amortizing payment instead.
Then the loan will amortize just as it would have if the interest-only
option had not been attached. After
5 years, the balance will be $93,054. If
you make the same payment on the same mortgage, you end up in the same place.
If
the borrower pays $700 a month instead of $599.56 on the same mortgage, the
balance after 5 years will be $86,046. Whether
the mortgage did nor did not have an interest-only option will matter not a
whit.
Misperception
3. An
interest-only loan carries a lower interest rate. Lenders might charge a
higher rate for a loan with an interest-only option, because the risk of default
is a little higher on loans that amortize more slowly. But a lower rate would be irrational.
The
notion that interest-only loans have lower rates arises from comparisons of
apples versus oranges. Adjustable
rate mortgages (ARMs) with an interest-only option have lower rates than
fixed-rate mortgages (FRMs) without an option.
But an ARM with the option does not have a lower rate than the identical
ARM without it.
Since
the interest-only option is available on both FRMs and ARMs, it is pointless to
be sucked into an ARM because of that feature.
First choose whether or not you want an ARM or an FRM. This decision
should be based on how long you intend to have the mortgage, and on your willingness to accept the risk of a future increase in the interest
rate in order to have a lower rate in the short-term.
If you opt for an ARM, then select the other ARM features you want,
including an interest-only option.
Misperception
4. On
an ARM with an interest-only option, the quoted interest rate is fixed for the
interest-only period. This might or
might not be the case.
Where it is not the case, this may be the most
dangerous misperception of all because it can induce borrowers to take ARMs that
don�t meet their needs.
The
interest-only period is the period during which you are allowed to pay interest
only. The period for which the initial rate holds is a different matter
altogether. On an ARM with a very low rate, the interest-only period is always
longer than the initial rate period.
A
common ARM today has an interest-only option for 10 years, but the initial rate
holds only for 6 months. On
a $100,000 loan with an initial rate of 4%, the interest-only payment is $333.
If the rate after 6 months goes to 6%, the interest-only payment would jump to
$500. Borrowers who thought they
were safe for 10 years would get a rude awakening.
November
20, 2003 Postscript
Misperception
5. Interest-only loans are appropriate if you don't expect to be in the
house very long. I don't know where this idea comes from, but it makes
no sense. If you don't expect to have the mortgage very long it makes
sense to select an ARM because the rate will be lower, and it makes sense to
avoid paying points because there won't be much time to recover your investment
through a lower rate. But the decision to take an interest-only should not
be affected by your time horizon.
February
10, 2004 Postscript
Misperception
6. Interest-only loans don't require PMI. Some loan officers are
shameless in the stories they tell borrowers, and this is another one. Of
course, some interest-only loans don't require PMI because the loan is too large
relative to the borrower's equity, or the deal is otherwise sub-prime. In these
cases, the borrower is paying the insurance in the interest rate.
If
there is a loan that requires PMI but does not require it if the loan has an
interest-only option attached, it would be because the insurer doesn't want the
greater risk entailed by the PMI. In such case, the implicit insurance premium
in the rate is bound to be larger than the PMI premium.
Copyright
Jack Guttentag 2004 |